Retirement

Rethink that Roth

12 traps to avoid when converting to a Roth IRA

BOSTON (MarketWatch) -- If the high number of phone calls to mutual-fund firms and the comments posted to articles on the subject are any sign, savers are showing a lot of interest in converting their traditional IRAs into Roth IRAs, but they should be wary about acting on that desire too hastily because some expensive traps are waiting for the ill-informed.

"Roth conversions can trigger unintended tax traps and financial problems that are not being addressed in the mounds of 2010 Roth conversion information that currently dominates the media," Ed Slott wrote recently in his newsletter, "Ed Slott's IRA Advisor."

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These traps may make you reconsider when to convert, how much to convert, or even if you should convert at all. Here are some of the traps that Slott says await the uninformed.

1. On a 2010 conversion, the income is split, not the tax

"While the income limitations for Roth conversions are repealed for 2010 and all subsequent years, 2010 is the only year that will allow taxpayers a special break on paying the conversion taxes," Slott wrote.

"Taxpayers who convert in 2010 won't have to include any conversion income on their 2010 tax return, and instead will include half the income from the conversion on their 2011 return and half the income on their 2012 return," he said. "But just because you evenly split the income over two years doesn't necessarily mean you evenly split the tax as well. In fact, that would be highly unlikely."

The total tax bill is going to depend on a number of factors, some totally outside a person's control, including tax rates and overall income.

2. 60-day rollover mistakes

The best way to move money from an IRA to a Roth IRA is by trustee-to-trustee transfer -- a direct rollover. But some company plans or IRA custodians don't offer this type of transfer, Slott said. Instead, the firms will simply write a check to you, the account owner, and send you on your way.

In such cases, you have 60 days to place these funds into another qualifying retirement account, including a Roth IRA. And if you don't make the deadline? "If the 60 days pass without the funds being re-contributed to another retirement account, the funds become taxable and are no longer eligible for rollover," Slott wrote.

The only fix for this is a private letter ruling, he said. PLRs, as retirement experts call them, can be costly and time consuming -- and there's no guarantee the IRS will rule in your favor.

3. Medicare costs and Social Security taxation

You might have to pay higher Medicare premiums or have your Social Security payments taxed if you do a Roth IRA conversion. That can happen if you are receiving these benefits and do a Roth conversion, Slott said.

"In general, Social Security benefits are excluded from the gross income of a taxpayer and are therefore not taxed," he said. "However, depending on how much other income an individual has, anywhere from 50% all the way up to 85% of their Social Security income can be included in gross income, resulting in a higher tax bill for that year."

What's more, he said, "Medicare Part B premiums are based on income. For 2010, joint taxpayers will remain at the lowest premium levels as long as they have income of $170,000 or less ($85,000 for those filing single). From there, premiums progressively increase until joint taxpayers have above $428,000 in income ($214,000 for those filing single). Conversion of a large IRA or plan balance could move you into a higher premium bracket, potentially costing a couple around $6,000 extra in Medicare premiums for 2010."

4. Financial aid loss

Most schools exclude a parent's retirement assets when considering a college student's eligibility for financial aid. "Income, on the other hand, is one item schools tend to look at intensely," Slott said. "And that's exactly what a Roth conversion creates. A Roth conversion will cause a spike in income for the year or years where the income is included. While this additional income is an aberration and does not represent typical income levels, it can cause a loss of valuable financial aid."

5. New Roth accounts need new beneficiary forms

The beneficiary form, according to Slott, is the most important estate-planning document when it comes to IRAs and Roth IRAs. It controls who ultimately gets the money in the account when you, the account owner, dies. Each custodian will have procedures in place for the conversion, but each new account you open will need to have the beneficiary forms completed properly and submitted.

6. Partial conversions involving after-tax money

When you have after-tax money in an IRA, you can't isolate the after-tax amounts and convert them tax-free while keeping the remaining pre-tax dollars in the traditional IRA, Slott wrote.

"That would be like trying to separate the cream from your coffee after pouring it in -- it just can't be done," he said. "Instead, when a partial conversion of IRA assets is done, a pro-rated amount of after-tax money, or basis, is included with each dollar converted."

The formula for calculating this amount is this: Total basis in all IRAs divided by the total value of all IRAs times the amount converted.

7. Rolling to an IRA mid-year

If you plan to roll your 401(k) into an IRA in the same year that you do the conversion, be sure to avoid this trap. "When an IRA is converted, only IRA assets are taken into consideration for the pro-rata rule," said Slott. "Plan assets have no effect."

For example, consider the case where someone has an IRA worth $50,000, of which $25,000 is non-deductible contributions and $25,000 is earnings, said Slott. This hypothetical person also has a 401(k) worth $450,000, all of which is pre-tax. If the person converts the entire IRA, he will owe tax only on $25,000 since the plan assets are excluded from the pro-rata formula.

8. RMDs must be taken first

Just when you thought you could get rid of required minimum distributions (RMDs) forever, this trap comes along. Yes, many IRA owners were waiting, breath bated, for 2010 so they could convert and stop taking those tax-causing RMDs. Well, 2010 has arrived, but those IRA owners have to be careful not to act too quickly.

"In their haste to convert, some IRA owners might convert their entire account balance not knowing that their RMDs cannot be converted to a Roth IRA," Slott said.

"Individuals who are 701/2 or older in 2010 must first take their 2010 RMDs if they plan to convert all their IRAs to Roth IRAs. The first dollars withdrawn from the IRA are deemed to be the RMD until that amount is satisfied. Once the RMD is withdrawn, then the remaining IRA balance can be converted," he said.

9. Some funds are not eligible for conversion or contribution

You might think you can convert anything into a Roth IRA, but you'd be wrong.

"The tax code allows only eligible rollover distributions to be converted to Roth IRAs," Slott wrote.

Besides RMDs, there are a number of other items that can't be converted, including 72(t) payments, hardship distributions, corrective distributions of excess deferrals, deemed distributions, and dividends from employer securities.

10. Non-spouse beneficiaries can't convert inherited IRAs

Besides the aforementioned, Slott said there's one type of account not eligible for conversion that merits special attention.

"Any non-spouse beneficiary who inherits a qualified plan is eligible to convert that plan to an inherited Roth IRA, and the plan must allow this transfer," he said.

"This conversion must be done by a direct transfer as non-spouse beneficiaries can never do a 60-day rollover. But, while a non-spouse beneficiary who inherits a qualified plan can convert to an inherited Roth IRA, if the same beneficiary inherits an IRA they cannot convert it to an inherited Roth IRA."

11. The SIMPLE IRA 25% penalty

All IRAs, including SEP IRAs and SIMPLE IRAs, are eligible for conversion to a Roth IRA. But unlike a traditional IRA or SEP IRA that can be converted anytime without penalty, SIMPLE IRAs present a dangerous trap, Slott noted. "SIMPLE IRAs have a two-year holding period. The two-year clock is unique to each participant and starts once they have made their first contribution," he said. "Funds that leave a SIMPLE in the first two years are treated as a taxable distribution that is not eligible for rollover other than to another SIMPLE IRA. They cannot be converted to a Roth IRA."

12. The 10% penalty trap

There's a 10% early withdrawal penalty when funds are withdrawn from an IRA before age 591/2, but the Roth conversion is an exception, Slott said. "IRA or plan funds withdrawn at any age are not subject to the 10% penalty if those funds are converted to a Roth IRA."

However, two tax traps can still trigger the 10% penalty, he said. One of these traps is if some (or all) of the funds withdrawn are used to pay the conversion tax. Since funds used to pay the conversion tax are not actually converted to the Roth, they are subject to the 10% penalty and income tax.

The second trap occurs when funds converted to the Roth are withdrawn within the first five years and the Roth IRA owner is still under age 591/2. You can't avoid the 10% penalty by first converting to a Roth IRA and then withdrawing converted Roth funds to pay the tax.

There are more traps awaiting the ignorant. Slott's best advice: In every Roth conversion, make sure you address each and every tax and planning detail -- preferably with a professional who knows what he is doing. For more about Slott, visit this site.

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